There are many different types of exchanges in existence, such as the New York Stock Exchange (NYSE) and the Chicago Board of Trade (CBOT). Generally these exchanges provide an open market for the purchase and sale of securities and commodities. Principle or designated market makers can be employed at these exchanges to maintain a market in securities and commodities. The market maker maintains a market by being on the opposite side of every trade.
The use of a human market maker in a trading environment is known. For example, the use of a market maker has been employed in connection with trading securities. Rules pertaining to the use of a Principal Market Maker (PMM) in futures markets have also been proposed by the Chicago Mercantile Exchange (CME) to allow the use of a market maker in a commodities environment. However, these rules have not been implemented. The CME's proposed rules for its Principal Market Maker (PMM) are similar to rules written by the Chicago Board of Options Exchange (CBOE), although adapted for exchange traded futures.
The PMM's functions are similar to that of a market making foreign exchange bank and broker specialist. A PMM specialist should continuously maintain a sized two-sided bid/offer market for its designated products. This market should be of a designated minimum quantity and maximum spread, i.e., the difference between bid and offer. Also, the PMM should maintain the "public order book" (collection of public customer orders to purchase or sell) with respect to the assigned products. Finally, the PMM should give priority to customer order execution over personal trading.
As compensation for the above functions, the PMM is typically entitled to participatory volume defined as the average daily pit traded volume for the preceding calendar quarter. For example, the PMM may be entitled to 40% of volume at the bid/offer price if volume is between zero and 2,500; and 35% of volume at the bid/offer price if volume is between 2,501 and 5,000. No entitlements are currently offered if volume exceeds 5,000 transactions per day. Additionally, the PMM is entitled to the retention of floor executed brokerage transactions commissions except where principal-agency conflicts of interest apply, or other arrangements have been made.
The foreign exchange spot cash market facilitates the exchange of currency between two parties. The actual currency transfer generally occurs two business days following the transaction date. At the close of business of each trading day, market participants roll or swap their open spot positions forward one business day. This enables the next trading day's position to be maintained in spot terms. Eventually, future spot positions are netted against existing positions.
The CME's Rolling Spot Currency contract parallels the quoted spot or cash market with a few notable exceptions: (1) the exchange makes an automatic daily adjustment for the "roll" via a cash debit/credit; (2) because the trades go through the CME Clearing House, many problems associated with interbank spot transactions are eliminated; and (3) all Rolling Spot Currency contracts currently have a standard size. Thus, the CME's Rolling Spot Currency contracts combine the price convention of the interbank market with all the benefits of the CME and its existing central clearing facility. Traders do not have to pay away bid/ask spreads on daily spot rolls because the CME's roll process, called the "Daily Adjustment," is performed automatically. The need for a credit-worthiness counterparty check is eliminated because the counter-party is always the CME Clearing House. Overdraft expenses are eliminated using Rolling Spot Currency contracts because there is no need to actually make a payment or accept a delivery as in the foreign exchange (forex) markets.
Unlike regular spot transactions in the foreign exchange markets, Rolling Spot Currency trades do not tie up bank credit lines. Therefore, institutional traders can conserve their firm's credit lines for other uses. Because Rolling Spot Currencies are a centralized exchange traded contract, these contracts allow all traders to obtain the same quotes regardless of their firm's credit rating or size. Quick access to cash flows can also be created by combining the CME's Rolling Spot Currencies with currency forwards to produce forward swap positions. In addition to freeing up credit lines, Rolling Spot Currency positions are not affected by the Bank for International Settlements' Capital Adequacy Requirement Standards.
By circumventing the tasks of funds transfer and multiple ticket writing to facilitate the roll, the CME replicates the one-day roll with a simple line entry and no deliveries. Furthermore, multiple trades transacted in the interbank market with several counterparties require separate ticketing for each buy and sell. The CME's Average Price System (APS) allows multiple Rolling Spot trades transacted throughout the day to be assigned an average price. The APS significantly reduces costly paperwork because the trader has the benefit of averaging all trades into single buy and sell tickets.
Previous attempts at providing an active interbank exchange traded currency market have failed. One reason that previous attempts have failed is because futures markets do not presently require nor provide the proper incentives to any trader or entity to deliver the service of a current 24-hour bid/offer and large quantity market. Failure of prior attempts to develop an interbank exchange traded currency has kept the transaction cost (the difference between bid and offer) of market participation in worldwide international currency trade very high because liquidity of the exchange traded futures market is relatively low vis-a-vis the interbank over-the-counter forex market.
Futures exchange traded foreign currency trading has failed to compete with the over-the-counter-forex market. The CME's foreign currency volume has recently declined, while over-the-counter volume increased. In addition, a "second tier" of currency trading banks have recently entered the "top twenty" group of currency traders. This suggests that market growth in foreign currency trading is dynamic, not static, and represents another failure of the current methodology of exchange traded foreign currencies.
Prior attempts have also been made by exchanges to capture market share in the area of currency trading which is established between the spot (current date transaction) and the short duration (1-14 days) of currency market derivative products. Foreign exchange average daily volume may be as high as 893 billion dollars. Two thirds of this figure may also represent forward and swap derivative transactions. These transactions represent an important untapped market for exchange traded currency products.
Another area in which exchange traded currencies have failed to compete is the area called Exchange For Physical (EFP). This area is currently a fast growing, off-exchange trade between Futures Clearing Merchants (FCM), which are analogous to brokerage houses in the securities industry. Because of the failure to provide a market maker with long term growth incentives to position itself in the market 24-hours per day, and to market and make the essential business contacts to promote its service and the exchange's products, exchange traded currencies are losing business to the EFPs. Furthermore, the EFP is another area of over-the-counter, unregulated currency trading which is developing to the detriment of world financial stability.
The greatest failure of the over-the-counter forex currency market is its inability to transfer risk in a timely, cost effective manner. The possibility of failure of one or more large currency market making banks is great because no present arena provides the vital service of efficient, cost effective risk transfer.
Prior attempts at capturing flexibility in establishing new innovative currency contracts and direct marketing contacts with currency trading personnel have failed on the major futures exchanges. This failure to innovate and communicate is also exposing the world to potential currency risk because exchanges cannot provide the necessary products to limit risk. By establishing a mechanism associated with an exchange responsible for making a market at all times and charged with the responsibility of marketing that presence, the futures exchanges will be able to provide a much needed service similar to a bank, but with all the inherent advantages of cost competitiveness and regulatory safety of an exchange.